No More Phony Accounting

Phony books played a central role in the financial crisis, but recent financial-reform proposals say virtually nothing about accounting. This omission is shocking. Simply put, the balance sheets of major banks were, and still are, fiction. Financial institutions did not, and still do not, disclose their true liabilities and true risks. If they had, we might have averted this crisis. Until Congress adds accounting to its agenda, and until financial statements reflect reality, financial reform will not work.

Accounting can be boring, so let me begin with a startling illustration. Below is a balance sheet, a real balance sheet, of a real company. Look at the numbers and try to guess which company it might be. While you are doing so, remember that the market declined sharply in 2007, crashed in 2008, and recovered by more than half in 2009. For most companies, the previous four years were a roller-coaster ride in which they soared, plunged, collapsed, and finally recovered (some). Now here's that actual balance sheet:

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2006 2007 2008 2009

Assets $1,884 $2,188 $1,938 $1,857

Liabilities $1,765 $2,074 $1,797 $1,702

Equity $120 $114 $142 $155

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These numbers look rock solid. Assets declined a bit since 2007, but so did liabilities. Overall, the net equity of this company has been rising steadily, apart from a minor blip in 2007. If these numbers are accurate, they represent a conservative and steady company, one that miraculously weathered the recent financial storm. Who might it be? Perhaps Starbucks? Or Wal-Mart?

In fact, this is the balance sheet of Citigroup. Yes, Citigroup. These numbers do not even hint that the value of Citigroup's business went from a quarter of a trillion dollars to nearly zero during this time. There is no indication that Citigroup suffered massive losses in 2007 and 2008 and then a major post-rescue recovery in 2009. There is no suggestion that Citigroup was insolvent, or close to insolvent, until the federal government promised to guarantee more than $300 billion of its debts. Instead, this balance sheet depicts an illusion of Citigroup as consistently healthy for all four years. The accuracy hasn't improved recently, either: The latest numbers in the chart are from a financial filing dated Feb. 26, 2010, just a few weeks ago.

This balance sheet is fiction.

And Citigroup is not alone. The balance sheets of every major Wall Street bank are just as fictitious. They do not reflect trillions of dollars of swaps. They do not include many subsidiaries, which banks use to avoid recording risks. Instead, the banks' exposure is off-balance sheet. Their financial statements do not show many of their actual liabilities. The dirty secret of the markets is that the financial statements of major Wall Street banks are false.

Consider the recent revelations about Lehman Brothers. Before its collapse, Lehman not only hid its derivatives liabilities from view but also used a scheme known as "Repo 105" to remove tens of billions of dollars of debt from its balance sheet. In March, after the Lehman bankruptcy examiner revealed some details about the scheme, members of Congress finally promised hearings into these false financial statements. Yet the legislative financial--reform proposals still do not require that balance sheets reflect reality. Indeed, they do not address balance sheets at all.

Some industry insiders will tell you that a formal balance sheet is no big deal. Supposedly, sophisticated analysts can uncover the data that is missing from the balance sheet, in footnotes to the financial statements. But even an investor who waded through the hundreds of pages of footnotes in a corporate filing would not have found deals like Repo 105 or the real exposure of swap liabilities at any major bank.

More important, the balance sheet remains a crucial document for financial regulation. Fools or not, regulators rely on financial statements. The balance sheet is the basis for numerous legal rules, including a bank's core ("Tier 1 and Tier 2") capital requirements. Investors look to balance-sheet numbers for a range of purposes. Until financial statements reflect something closer to the actual assets and liabilities of our major financial institutions, regulators will not be able to assess the risks of these institutions, the markets will not properly function, and another crisis will be just around the corner.

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Abusive off-balance-sheet accounting triggered the daisy chain of dysfunctional decision-making by misleading investors, markets, and regulators. False accounting facilitated the spread of the bad loans, securitizations, and derivative transactions that brought the financial system to the brink of collapse. Bankers became predisposed to narrow the size of their balance sheets, because they knew investors and regulators use the balance sheet as an anchor in their assessment of risk. Bankers used financial engineering to make it appear they were better capitalized and less risky than they really were -- and still are.

Wall Street lobbyists argue that fixing off-balance-sheet transactions would be too complicated. But these accounting problems are neither new nor complex. Indeed, Congress confronted similar problems in 1933, when it investigated the accounting shenanigans of the 1920s, such as the far-flung schemes perpetrated by Ivar Kreuger, known as "The Match King," whose securities were the most widely held in the world. During the New Deal, Congress' straightforward remedy was to require ample disclosures and to enforce stiff penalties when companies failed to accurately disclose their risks. That approach cleaned up the financial system back then, and we need to adapt the same core principles now.

Transparency and enforcement are simple but crucial reforms, and most people understand their importance. If the balance sheets of Citigroup or Lehman or American International Group or Bear Stearns had been accurate, they would have shown massive exposures to opaque financial instruments and securities and derivatives based on sub-prime mortgages. But they did not. The details are complex, but the problems posed by off-balance-sheet accounting are quite obvious to ordinary Americans. What if the next time you wanted to borrow money, you didn't have to list most of your debts? What if Congress let you keep your credit-card bills and mortgage liabilities hidden from view? How much would you borrow? How would you spend or invest that borrowed money? How much risk would you take? The answers do not require an MBA. Common sense tells us that if we let people hide their debts, they will borrow more than they should, at the wrong times, for the wrong reasons.

Lynn Turner, the former chief accountant at the Securities and Exchange Commission, and I recently proposed a straightforward fix to the off-balance-sheet problem: Require that balance sheets reflect reality. We even included proposed language for Congress to adopt. It is just one paragraph (with a second paragraph anticipating some of the objections Wall Street might raise). It wouldn't take long for Congress to add this language:

"The Securities and Exchange Commission, or a standard setter designated by and under the oversight of the Commission, shall, within one year from the enactment of this bill, enact a standard requiring that all reporting companies record all of their assets and liabilities on their balance sheets. The recorded amount of assets and liabilities shall reflect a company's reasonable assessment of the most likely outcomes given currently available information. Companies shall record all financings of assets for which the company has more than minimal economic risks or rewards."

That's it. With this simple reform, Congress could mandate that companies report all of their assets and liabilities. Companies that omitted material assets and liabilities from their balance sheets would be subject to civil liability in the same way companies generally have been exposed to private rights of action for material misstatements. This is not a radical proposition: It is precisely what Congress did in 1933 and 1934, in response to that era's financial crisis.

Accounting reform is absent from today's debate, not because it is partisan but because concentrated Wall Street powers wield more influence than the diffuse interests of Main Street. In principle, Democrats and Republicans agree that market capitalism requires transparency, or it will not function properly. But it also is clear that transparency reduces the profits of Wall Street banks. They do better operating in the dark, in shadow derivative markets that are hidden from public view. Accounting reform is a test of whether members of Congress will respond to hundreds of millions of dollars of campaign and lobbying expenditures by banks or to the needs of most investors and taxpayers.

Average Americans understand what can happen if people are permitted to lie about their debts. The rest of us include all of their liabilities on our financial statements. Banks should, too.

About the Author

Frank Partnoy is the George E. Barrett Professor of Law and Finance at the University of San Diego. His most recent book is The Match King: Ivar Kreuger, The Financial Genius Behind a Century of Wall Street Scandals.